Thursday, May 26, 2022

Property Financials 102: Accrual vs. Cash Accounting (and Why it Matters)

All right welcome back to your ongoing pursuit of your bachelor's of multi-family science here at the apartment academy this is part two of our discussions surrounding financials here in the multi-family industries only operations focused podcast where we feature insights from industry .

Leaders investors vendors and technology providers or in this case insights from yours truly uh and so if you invest in multi-family real estate or you're you're involved in day-to-day on-site operations of apartment buildings we're your source for efficient operations and maximizing .

Noi so last time we were talking about in part one of two the typical financials that you expect to encounter when you're operating apartment building and some of the meanings behind some of the definitions and and numbers that you see and we sort of wrapped up in part one talking about the income statement all .

The definitions on the income statement and i want to talk about now kind of a subject that affects how that income statement looks and that is whether or not your property follows accrual or cash accounting now i'm not an accountant so everything i'm everything i'm going to speak to today everything i .

Speak that i spoke to in part one all of this i'm trying to just use and i am using just layman's terms to talk about these things and and the same is going to apply here to accrual versus cash because that's how i understand and i think it's the easiest way to explain it um to you the apartment academy listener .

So your property your owners will will elect to follow either accrual or cash accounting let's start with cash cash accounting is very simple to create it's very simple to understand when somebody pays you rent if you get five dollars in rent you put on your income statement that i received five dollars when you pay an .

Invoice and you pay fi you pay somebody five dollars you put that on your uh income statement on the expense side that says i paid five dollars and if that's all you get for the month at the end of the day you earn five dollars in rent you paid five dollars out in expenses you have zero net cash .

Flow for the month okay it's very easy to understand um but there are some downsides to that kind of accounting and the downside is that expenses can vary wildly month to month and any given month .

May not represent kind of what the what the average expense should be and you might be understating or overstating your cash flow for that month and that's meaningful if you're first of all a lender who's trying to understand what what they can expect what kind of cash flow this property should expect to receive over time .

And it's also it's also deceptive to investors who might think they their their property's throwing off more money than it should because you forgot to pay a utility bill which will re in in cash accounting will increase your cash flow for that month accrual accounting accounts for that so one very common thing that that gets .

Fixed in accrual accounting is there there are utility invoices that sometimes only get paid every other month if you're using cash accounting your your all other things being equal your cash will go up one month and down one month and up one month and down one month just with the payment of utility .

Bills and you've got to figure out which one of those months represents the actual like project projected cash month for the next month you've got to go through i mean if you could just average it and say okay well on average i've been accrual counting takes that out of the equation .

So where in a cash accounting you count money when it's received and you count expenses when they're paid in accrual accounting you count income is recorded when it's earned okay so that means that you uh you somebody owes you that five dollars in rent .

And may or may not have paid it to you yet but because it's owed it gets booked on the income side on your income statement okay and expenses are recorded when they're incurred but not when you pay them necessarily so even though you didn't receive a gas bill this month because only paid every .

Other month you incurred a gas expense you may have to guess at what that is but accrual accounting demands that you you register your actual expenses incurred on any given month or that if you pay something for the entire year let's say you pay your insurance up .

Front for the entire year one twelfth of that expense actually belongs in the expense of every single month so you might have paid it in cash up front but you're actually only going to recognize one twelfth of that expense every month over the coming year this normalizes .

Your financial outlook for that property it is why investors and as specifically lenders want to see accrual accounting it's more difficult it's more timely you have to if you didn't get an invoice you didn't get a a bill that you expect you have to .

Remember that and you want to go ahead and book it as if you received it anyway so there's a lot more management to it but what you end up with is an income statement that at the end of the day is more meaningful okay but you're going to need the cash flow statement to really fully understand the the the actual cash that went into .

Your pocket at the end of the day whereas when you're using cash accounting the bottom line of the cash accounting income statement is generally the cash that you're left with at the end of the day the income statement for an accrual uh property whatever it says is net cash flow at the end of the day or free cash .

Flow might not be the actual cash that you walked away with that you that that you put in your pocket so you need the cash flow statement to understand what actually happened at the property on an accrual basis because the cash flow statement will do things like if you anticipated .

Hey i didn't get my utility bill this month but it was about fifteen thousand dollars on the accrual side that will reduce your revenue by fifteen thousand dollars it'll count as an expense but you didn't pay that bill you're just .

Allowing for it you're accounting for it you actually still have that fifteen thousand dollars in your pocket so your cash statement will reflect that like the things that you that you accounted for but didn't actually use your cash it will also do the reverse it will it will account for things that um .

You accounted for that you received cash floor but you didn't actually get that money so you might you might be owed rent from a unit they might owe you five dollars in rent and on the income statement it's going to reflect the amount of rent that was owed to you but if they didn't pay you that rent you don't have that cash in your pocket .

And the cash flow statement will reflect that the cash flow will adjust and it'll say all right you said you were owed a hundred thousand dollars in rent um uh fifteen thousand dollars worth of rent was not actually collected so it's gonna subtract that um from your from your bottom line to to .

Adjust down to an actual cash number okay and that's the purpose of a cash flow statement is to take your income statement and adjust it to an actual cash number a lot of times that's the same as a cash income statement if you're doing cash .

Accounting but if you're doing a cruel accounting you're going to need the cash flow statement to adjust down to a cash number one other thing i want to point out about accrual accounting is that the expense of a debt service the principal piece of that .

Is not on your income statement only the interest is reflected as an expense of the property the principal piece that you pay is a retirement of a liability and a liability is on your balance sheet so if .

You a million dollars um in to the bank right and your payment that month is twenty thousand dollars nineteen thousand of which pays interest one thousand of which pay goes against the principal the nineteen thousand dollars will show up on your income statement the one thousand dollars that you pay that goes .

To principal will go on to the balance sheet it will reduce your balance from one million dollars to nine hundred ninety nine thousand nine hundred ninety nine thousand nine nine nine dollars whatever that is um and um and so that reduction in principal payment and principal balance .

Is uh reflected uh on the balance sheet but also the thousand dollars that went to that is a use of cash and shows up on the cash flow statement i hope that makes sense but it is one of the things that often tricks people when they look at it at an accrual income statement .

And they say oh i made three thousand dollars this month what they don't realize is no there's they had to pay that only that part of the debt payment is missing from the income statement part of that debt payment is on the cash flow statement the principal piece and actually they lost two thousand dollars .

That month because they had to pay five thousand dollars that went to um to pay down principal on the on the uh on the debt service but again the benefits of accrual accounting getting properties refinanced giving investors predictable income that they can look and predict .

Cash flow shortages or distributions you can't do that reliably on a cash income statement you need to use an accrual income statement cash is easier it's a lazy way to do it but it's not as insightful so keep that in mind so now let's talk a little bit about the three .

Different the three different uh statements and just uh how you need to be looking at them on a monthly basis we've talked a lot about the income statement and the things that are on there what should you be looking for on a monthly basis when the financial statements are produced they want you to .

Review them what are you looking for first of all very simple tip number one use the trailing 12 income statement to review any one months any given month's income statement use your trailing 12. what the trailing 12 means is it shows you for every for the prior .

11 months for every line item it shows you what your income and expense items were and it's the easy way to pick up anomalies you're looking for anomalies you want to look across the vacancy loss item you want to see that the vacancy loss is more or less the same if this month something has a big vacancy loss .

Number that's a red flag you want to pick that up you also want to look at your again i'm now going to talk mostly in terms of recruit accounting because that's you know if you're a professional manager you're probably dealing with accrual accounting you want to look to see that loss to lease is being reduced over time that .

Means that as you as units are rolling you are achieving market rent for those units and so the difference between your your market rent and your your in-place rents is slowly narrowing so you want to see that go up that all happens better in in comparing a 12-month trailing statement than it does looking at an .

Individual income statement on its own same thing goes for the expense side you want to look at expenses you want to see more or less pretty much steady state expenses in things like utilities you'll see seasonal changes for sure but but you want it you don't want to see big spikes you don't want to see big spikes in the water bill .

Because if you see a big spike in the water bill means you probably have a water leak and that's the kind of thing you want to be scanning for in unit turns are going to the expense for unit turns that's going to vary wildly depending on how many you know units you have rolling in any given month so it's common to see um it's .

Common to see that um vary you want to make sure you want to look at your line item where you're showing resident charges um when when a resident moves out you should be charging them for damages if the line item for resident charges is zero in any given month it could mean that somebody forgot to charge the .

Resident who's moving out you know damage charges and there is always at least cleaning charges and there is oftentimes damage charges so you really should that line items shouldn't really be zero you want to look at you know debt payments and taxes these should be fairly steady if those amounts went up .

Uh you know if it's the end of the year and your insurance rates go up you want to make sure that that you see those go up and that somebody's not still carrying the same accrual that they were carrying before and forgot that you it's you you've now you're into a new insurance year and that rates have gone up .

So using that trailing 12 to look for anomalies is really important so on the cash flow statement you're going to look for odd uses of cash first of all your capital expenditures will all be on the cash flow statement so you want to make sure what you're seeing there represents what you believe to be an .

Appropriate classification of those expenses you don't want to generally see just regular maintenance items being capitalized that's usually not appropriate again you can have owners and investors we've talked about in in part one who want you to capitalize as much as possible because they want to .

Make the property look very profitable in any given month you can see them trying to hide things by capitalizing it and also you want to make sure that if you've had any big major expenses or replacements like boilers hvc equipment you want to make sure that that's showing up there in the cash flow .

Statement it wasn't accidentally expensed on the expense site again unless you have an investor or an owner who is asking you to try to carry as much on the expense side as possible you want to look at accrued trade payables that those accrued trade payables line .

Items is an indication that bills that aren't getting paid and so if you if your accrued trade payable is going up it means somebody's not paying bills uh you you won't see that on the income statement it will look fine but only the cash flow statement will tell you that .

The property is not paying its bills you want to look for delinquent rent so if delinquent rent is going up it means that somebody's not collecting rent just realize that the delinquent rent number on the cash flow statement is the net of uncollected rent from the prior month that was collected .

Versus against rent that was due this month that was not collected so the difference you're seeing on the cash flow statement is the net of those two numbers just remember that and then uh on the cash flow statement the last thing is you you want to look for .

If you have a loan um you want to make sure that the that the debt payment the principal piece of the debt payment is being is being accounted for on the cash flow statement as well finally the kind of the the lonely step child of the of the three financial statements is the balance sheet i rarely .

Met a property manager or even a regional property manager who's looking at the balance sheet but there are a few important things on that balance sheet that you need to be you need to be aware of so the first thing to look for on a balance sheet is are your security deposits .

When you receive a security deposit it is not income it should not be reflected on your income statement um it is essentially a liability you've got to give that money back somebody at some point less whatever damage charges you're going to assess so your security deposits that that you have collected .

Should be there on your balance sheet um the liability for security deposits that you owe should be there as well and you want to make sure that you have enough security deposits to cover your security deposit liability i've seen a lot of properties that get .

In financial difficulty and the owner rather than contributing capital to cover you know any operating deficits instead the owner uses their security deposits as operating capital that's a terrible idea but it happens and if it's happening you will see it on the balance sheet because .

You will not have the security deposits reflected there uh to cover the the liability that it should be there so on the on the asset side should be security deposits you have on hand on the liability side should be uh the the liability of security deposits that you will in theory owe when people move out it's the .

First thing to look for you also want to look for your unpaid rent so the unpaid rent represents an asset it is it is money that you are that you still expect to collect um but every month that somebody doesn't pay you rent and you and you don't collect it that unpaid rent is going .

Into this bucket this this on this unpaid rent bucket because until you say differently the financials expect that you're going to collect that rent at some point so that number can grow substantially and represent an asset of the property in in in that case being money you expect to collect at some point that isn't real these people .

Have moved out there they're they're never going to pay the rent that they owe you for whatever reason and so you need to at some point write out write that off off of your balance sheet you should make that decision on a monthly basis how much of the rent that's reflected on the balance sheet is .

Uncollectible and write it off so that that number doesn't become a large number just remember that when you write it off that write-off then becomes an expense because you are you are you have to reduce your income item that you that you said you were going to collect a month six months or a year ago .

Now you're going to write it off so it will go on to the on to uh onto your income statement but you need to look for that you want to make sure that your security deposits and that your unpaid rent are in line with your expectations other things you can look for you want to look for just to make sure that the .

The principal balance of your your loan is correct um you want to make sure that any capital contributions that your owners may have made is reflected properly so just a cursory review of the balance sheet on those items is probably enough we could talk a lot about some other things that show up on the balance sheet .

But that's what i think you really need to be focused on um you know when you're on the operations side okay so we've been through the high level of the other financial statements let me just leave you with some other metrics that you want to be thinking about as an operator and you want to be aware of and tracking month over month .

So occupancy of course obviously economic occupancy economic occupancy is a very interesting and compelling number that you're going to want to calculate every month to illustrate economic occupancy in a in a overly simplistic fashion you might be 100 occupied but if 50 of those people .

Are there because they receive free rent that month your economic occupancy is only 50 you're only receiving rent as if 50 of the people were paying or occupied because only 50 of them are paying so that's economic occupancy and it can reflect the impact that concessions are having uh on your financials uh percent least .

Um that um the least percentage to me the way we've always spoken about it is not what percent is not the same as percent occupied percent least is a trend percent least looks at what your occupancy is today how many uh notices you have coming up for people that intend to leave .

And how many of those are pre-leased so it's looking 30 or 60 days down the into the future say what is my you know what is my future occupancy looking like right now what percent least am i um another great metric that everyone should be looking at um effective rent uh versus uh rent so effective rent is um kind of the actual rent .

That you're receiving when you take into account concessions so your monthly rent might be 1200 dollars um but if you've given them a one month concession you take that one of 1200 you divide that over a year so one hundred dollar one hundred dollars a month .

Your actual effective rent is not twelve hundred dollars it's twelve hundred minus one hundred dollars so eleven hundred dollars a month is actually your effective rent um that's important to track your effective concessions as well your lease renewal percentage so when a unit comes up for renewal what percent of those units are renewing .

And are staying with the property most owners want to see something very high right you want to see above 60 some some owners want to see something very high uh some owners will really be pushing rent some operators will want to really push rent and because it's a hot market and in that case your lease renewal percentage may go down and .

That's okay with everybody but everyone should be on the same page as what your expectations are and should be tracked debt coverage ratio we talked about that debt coverage in session one debt coverage ratio is the ratio of your noi to your actual debt service and it should be greater than one if it's less than .

One you're in trouble if it's less than 1.1 you're probably um in trouble or you're very close and you might be in violation of debt coverage uh covenants that uh are that the bank is looking for and you're at risk of the bank instituting uh protectionist measures .

That that could include for example uh forcing you to deposit all of your rents into a lock box so that they take the rent and pay themselves first and then give you the rest for expenses so you want to watch your debt coverage ratio delinquency percent of course um you know three percent five percent delinquency is generally acceptable .

You want to track your lease expiration curve you do not want a hundred percent of the property all checking out in december um you may want more people uh checking out in the summer than you do in in december so you want you you should establish what your desired lease expiration curve .

Is so that you can set your leases your lease durations based on trying to fit that lease expiration curve there are a number of marketing analytics you want to be tracking you know what you know what for each one of your advertising sources how many leads are they throwing your way what are you paying them for those .

Leads so your cost of each lead you want to be tracking that as well and lastly resident satisfaction you should be serving your residents on a regular basis you may even be serving employees and that's becoming more and more important uh and tracking resident satisfaction resident satisfaction is a precursor to retention so you want to .

Make sure that residents are happy and and regularly performing a resident satisfaction survey allows you to get in front of any problems before the resident gives you a notice so all of those items ideally you're producing every month uh and if you do that you will have a very good picture .

Of the health of the property that goes beyond uh just the financials themselves so i hope you took good notes on all of that um but as you say look the only test you'll have is is is awaiting you in the leasing office every day back on site so .

We appreciate you joining us for part two here of our financial discussion here at the apartment academy if you've listened to these podcasts and and you feel like you're management companies you could use a little advice from some of the professors here at the apartment academy then go to our website apartmentacademy.com and click help me .

We'll send you a questionnaire and provide individualized responses to your answers at no charge that i guarantee will offer you insights on ways you can immediately improve apartment operations thanks again and i look forward to joining you again when class is in session .

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